Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evalu
ID: 2476865 • Letter: S
Question
Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evaluating the acquisition of a new embroidery machine. The budgeted operating income of the Teen division was $5,200,000 with total assets of $32,700,000 and noninterest-bearing current liabilities of $1,600,000. The proposed investment would add $1,014,000 to operating income and would require an additional investment of $5,279,000. The targeted rate of return for the Teen division is 13.60 percent. (Ignore taxes in this problem.)
Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evaluating the acquisition of a new embroidery machine. The budgeted operating income of the Teen division was $5,200,000 with total assets of $32,700,000 and noninterest-bearing current liabilities of $1,600,000. The proposed investment would add $1,014,000 to operating income and would require an additional investment of $5,279,000. The targeted rate of return for the Teen division is 13.60 percent. (Ignore taxes in this problem.)
Explanation / Answer
solution:
(1) ROI if machine is not purchased:
Total assets =$32,700,000
ROI = Net Operating income
Total Investments
ROI = $5,200,000 / $32,700,000 * 100 = 15.09%
(2) ROI if the machine is purchased
Additional investment = $ 5,279,000
Total assets = $32,700,000 + $5,279,000 = $37,979,000
Net operating income = $5,200,000 + $1,014,000 = $6,214,000
ROI = $6,214,000 / $37,979,000 * 100 = 16.36%
(3) Residual income = Net operating income - (Avg operating assets * minimum required rate of return)
Avg operating assets = Total assets - current liabilities
= $31,100,000
Residual income
= $5,200,000 - ($31,100,000 * 13.60%)
= $970,400
4. If machine is purchased
Total assets = $32,700,000 + $ 5,279,000 = $37,979,000
Avg operating assets = $37,979,000 - $1,600,000 = $36,379,000
Residual income
= 6,214,000 - ($36,379,000 * 13.60%)
=$1,266,456
If the performance is evaluated in terms of ROI then Sara should purchase the machine as it is much higher than the required rate of return i.e. 13.60%.
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